Michael Stahel, Partner and Portfolio Manager at LGT ILS Partners describes how tearing down the wall between the reinsurance and capital markets has fundamentally altered the reinsurance cycle.
Speaking to Artemis following the 2016 Rendez-Vous de Septembre in Monte Carlo, he also explained why Solvency II would encourage cedants to buy more collateralised protection.
How is the reinsurance cycle changing? Will we see the same peaks and troughs that we saw in the past?
We believe that the reinsurance cycle is a thing of the past and it’s very unlikely that we will see the same cycle movement as in the years 2006 (post Katrina) again. It resulted from the fact that it was difficult to raise additional capacity after extreme event scenarios. With the introduction of insurance-linked investments and ILS managers what has happened is that this wall between the reinsurance world and the general capital markets has been torn down and capacity can move far more freely between the different markets.
Many ILS managers such as ourselves have money waiting on the sidelines. Virtually all investors have a strategic long-term investment in this sector but could easily upsize their allocation if an opportunity arose. So if there is a significant increase in demand for more capacity resulting from extreme events, such capacity will be made available – I wouldn’t say instantly – but very quickly. As a result, extreme upswings in premium resulting from an event scenario should be smoothed out.
How will the industry need to adapt to this new normal?
If any underwriting team has a very strong focus on cycle management then it’s the ILS managers such as ourselves. We look at the risk level and expected loss of every single transaction and we need to generate some meaningful return above this expected loss level for our investor base – and after cost. So ILS managers typically only underwrite profitable business, otherwise our clients will ultimately withdraw their ILS allocation and allocate to other areas in the broader financial market.
That’s a key lesson we learnt from the current market environment: you can no longer subsidise one business area with profits from another business area, each business line itself has to be profitable.. Having said so, we certainly value diversification and attach a distinct value to each transaction, always in conjunction with the diversification value added to our portfolio.
Are we nearing the bottom of the cycle?
We believe that we have reached the bottom of the cycle for the very simple reason that we as ILS manager are unable to support a further decrease in rates. Our investors are institutional investors – they’re very smart, very astute and they would simply reallocate to other asset classes if we failed to hold firm. So when we’re discussing renewal terms we’re firm on rates because if we gave in and allow for reductions, our clients may start to reduce their allocation to ILS. So yes, we are at the bottom of the price cycle.
Where are the current opportunities from an LGT perspective?
There is not much organic growth in the market at present so the key focus for us is to replace and win mandates and capacity from other traditional markets. We are working with our counterparts, which are typically primary insurance companies, to allow for assessing the value of fully collateralised protection against traditional reinsurance protection. The key driver is the solvency capital requirement and the benefit of buying collateralised protection which comes without credit risk.
European insurance companies are now concluding the adaption of the Solvency II framework and are writing their first Solvency II reports. They are starting to see the real benefits of buying collateralised protection. So we believe while the market will not grow significantly, we can see that the ILS market will grow over the next year, so we have a positive view for 2017 and we believe there will be plenty of opportunity for us to write more business and new business.
We have been doing this for ten years now and for me personally this was my 15th Monte Carlo meeting. So yes, we have built up a presence and solid franchise in the market. We’ve also paid significant amounts in claims payments over the years – we’ve paid claims for Katrina, Hurricane Ike and Tohoku, to name some events – and people do remember that. Due to our profound diversification strategy these payments have never had an genuine impact on the performance of our portfolios.
From a strategic perspective, we have continued to increase our allocation to reinsurance and have also started to assess an allocation to corporate business. Companies like the Metropolitan Transportation Authority have issued cat bonds and are potential buyers of collateralised reinsurance. There are many MTAs out there – corporates big enough and with their own captive structures in place to buy directly from ILS managers and these are the companies that we want to engage with.
What would it take at this stage to really test the market?
What could test the market to a certain degree is a very unexpected event that raises a lot of questions – or then a series of significant mid-sized events. If you look at the events of 2011 with the New Zealand Earthquake, Tohoku and the Thai Floods, which was one of these unexpected events, and if you just accelerate that scenario slightly, such a scenario has the potential to change the market. It would shake up some of the existing household names in the reinsurance industry and also lead to some losses for ILS managers.
So far 2016 has been a bad year for attritional losses so far and yet the ILS market has generated healthy returns because we haven’t really been involved in this year’s events. But if you look at reinsurance companies’ returns, virtually all of them have reported negative returns for the first half of the year as a result of the increased cat loss burden. This is another indication that pricing for 2017 will see some stabilization – reinsurers will have to apply a closer focus on the technical underwriting returns for all business lines.
Do you have any ambitions to add a rated reinsurer or balance-sheet?
We believe the greatest value we offer as an ILS manager is the collateralised element of our capacity. By running a leveraged reinsurance book as an ILS manager, you defeat the purpose of collateralised reinsurance. Yet on the other hand, we can see the merits of running a rated carrier when it comes to the operational element of conducting business. It’s much simpler than conducting individually collateralised deals as you don’t have to post collateral for individual transactions. So while we don’t feel the levered reinsurance model is something that brings more value to the market at this stage, we are certainly assessing opportunities to continuously improve our access to business, such as risk carriers, joint ventures and hybrid forms of protection transactions.
Thanks to Michael Stahel for his time and ILS market insight.
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